What’s Next for the Luxury Sector?

by Charles Sizemore | August 30, 2013 8:59 am

The luxury sector has been in the headlines this week, though the outlook for the sector has been muddled.

High-end home goods retailer Williams-Sonoma (WSM[1]) beat earnings estimates on Wednesday, initially sending shares higher. Unfortunately, the details were a lot less impressive. Sales were up 12.3% and same-store sales increased 8.4% … but the retailer had to lower its prices — and thus its margins — in order to generate those sales, and management gave guidance that suggested the rest of the year would be tepid.

This came just a day after luxury jeweler Tiffany& Co (TIF[2]) announced strong earnings and boosted its forecast for the rest of the year. But, most importantly, it was a surge in Chinese sales that pushed Tiffany higher. U.S. growth was actually a little on the sluggish side.

It’s never a great idea to draw firm conclusions from just two data points, but this has been a recurring theme for most of the summer. Last month, British fashion group Burberry (BURBY[3]), announced a knockout quarter, with sales up 21%. Growth in China — Burberry’s most important market — was particularly strong.

Across the English Channel, Hermès — which trades on the France Stock Market under the ticker RMS — also surprised the Street. The French luxury group, best known for its leather goods and scarves, posted stronger-than-expected sales for the quarter led by a strong showing in — you guessed it — China. American sales have been decent, though far from spectacular. Any real success has consistently been in China.

Between sales in China and sales to Chinese travelers abroad, the Chinese consumer is the engine that drives this entire sector. European sales have held up fairly well, though this is in large part thanks to aggressive buying by foreign visitors.

Data here is a little hard to come by, as stores generally don’t track the nationality of their patrons. But as a telling case in point, Chinese visitors make up only about 1% of the traffic in London’s Heathrow airport, yet they account for nearly a quarter of all luxury goods sales[4].

But not all news coming out of China is good. Last month, Rémy Cointreau (REMYF[5]), the maker of high-end French cognac, announced disappointing sales stemming from a sharp decline in China. Rémy, which makes the ultra-high-end Louis XIII cognac, gets more than 40% of its sales from China. As goes China, so goes the company.

What are we to make of all this?

To start, despite an improving American economy, the luxury story begins and ends with China. This was bad news earlier this year for certain segments of the sector — such as Swiss watches and super-premium wines and spirits (Louis XIII cognac and Chateau Lafite Rothschild wines) — because of a Chinese crackdown on conspicuous consumption and on “gift giving” (ahem … bribery) in government circles.

This was less of a problem for handbag and fashion retailers. As the shock of the crackdown wears off, these segments should recover. But the short-term hit to sales will be felt in the next round of quarterly earnings releases.

Meanwhile, in other segments of the luxury market, it’s business as usual. Daimler (DDAIF[6]), the maker of the iconic Mercedes-Benz, just announced that it was making $2.6 billion in new investments in China[7]. Daimler plans to double its manufacturing capacity by 2015.

So, with all of this said, should you invest in the luxury sector?

I don’t consider the sector the screaming bargain that I did a year ago, but I still see quite a bit that I like. Daimler is one of my favorite stocks (and my choice in InvestorPlace’s Best Stocks of 2013[8] contest … which it happens to be winning at the time of writing). Daimler is up more than 30% this year, including dividends, yet the stock still trades for a very attractive 8 times earnings. It also sports a respectable 4.2% dividend.

I also like Swiss watch leader Swatch Group (SWGAY[9]). In addition to its own highly successful brands — such as the Omega worn by James Bond[10] — Swatch also makes the “guts” that go into 90% of all high-end Swiss watches. Swatch trades for 17 times earnings and yields 1.24%.

China’s growth looks to be stabilizing at around 7.5%. The days when Western luxury firms could count on 20% per year annual sales growth are probably over, but the “luxury story” will remain the “China story” for the foreseeable future.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long DDAIF and SWGAY. Click here[11] to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.